Defi Concepts: What Is Liquidity Pool & How Does It Work?
What is Liquidity Pool & How To Earn From Liquidity Pool in Defi Ecosystem?
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I often feel that:
“ Decentralized finance is the more democratized version of our current financial system which will mature over the period of few years to make people more independent and responsible with their digtial money ”
The year 2020–2021 has seen multiple Defi projects being launched in the crypto universe, some of the amazing Defi concepts which club together to fuel our Defi ecosystems.
Decentralized Finance or DeFi is a digtial revolution that leverages decentralized networks to transform our old & ailing financial system into trustless and transparent protocols that run without any third party custodians or intermiediary .
Some of the core concept driving this thriving Defi universe are
- Yield Farming
- Crypto Staking
- Crypto lending
- Crypto Borrowing
- Liquidity Pool
All these concepts allow crypto Hodlers to make use of their coins/tokens in earning some extra income in exchange for supporting the smooth functioning Defi ecosystem for their active participation and risk-sharing. Both borrower and lender reap rewards for empowering this financial engine. Liquidity pool is one such core concept lying at the heart of Defi world, which we will deep dive into and explore together.
We will navigate this Defi concept covering the following key topics
- What Is Liquidity Pool?
- Why liquidity pool is so important?
- How does it work?
- Exploring Some Defi Projects using Liquidity Pool Concepts
- Challenges & Risk Associated With Liquidity Pool
- Food For Thought & Summary
What Is Liquidity Pool & Why It Exists?
In Defi economy there are multiple pieces which work together to help user trade their crypto fund and earn rewards, these pieces are
- AMM(Automated Market Maker )
- Lending-Borrowing Protocols
- Yield Farming
- Synthetic Asset
- Blockchain-based games
and many more, liquidity pool lies at the core of each of these ideas,
So the simple definition of Liquidity Pool Is:
“ It is a reservoir of crypto funds mostly in pairs, which works based on the smart contract rules , facilitating user to engage in decentralized, permissionless trading, lending, borrowing activities and in turns getting rewards in the form of the crypto.”
Decentralized exchanges like UniSwap, Sushipswap, Curve, Balancer use the concept of liquidity pooling, to fuel their market. Dex participant willing to act as a Liquidity provider(LP), pools their token in pair to create a market, they get trading fee as a reward for facilitating transactions like token swapping, lending, borrowing, etc, happening against their pool. These rewards are proportional to their share of the total liquidity provided.
Tokens being pooled can be either ERC-20 tokens(For Ethereum based Dex) or BEP-20 for platforms like PancakeSwap, BakerySwap, and BurgerSwap, etc.
Did you know :
“Bancor is the first protocols to use the concept of liquidity pools”
How Does Liquidity Pool Works?
In order to understand the functioning & utility of the Liquidity Pool, we first need to understand how trading happens in our traditional centralized exchanges.
Akin to the stock market our crypto exchanges viz, Coinbase, Gemini, Kraken, Binance, etc, use the concept of Order Book, allowing traders to engage in buy or sell orders.
What Is The Concept Order Book?
The order book is like an electronic record of buy and sell orders for specific security, cryptocurrency token/coin, or financial instrument organized by price level.
Buyers are interested to buy any stocks/cryptos for the lowest price possible, while seller tries to get the maximum price for their stocks or crypto. Now, these trades get locked in the order book, where the consensus on price is required from both parties to get the trade executed.
So there can be a situation where the consensus never happens and trades never get executed for a longer period of time, why because there are not enough takers and also due to a liquidity crunch in the exchange.
These problems are tackled by the concept of the Market maker. These market makers put forth their desire to buy or sell the digital asset thereby providing the required liquidity to the market, this eventually supports quick, buy, and sell trade to happen for participating traders in the exchange.
Order Book & Market Makers Are Not effective For Defi, Why?
As discussed above in the world of a centralized exchange, the order book has a role to play, which gets support from Market makers to support the market liquidity. Centralized exchanges do have a high level of liquidity to facilitate the smooth buy & sell trade, but this is not effective for the decentralized finance world.
In Defi, dependency on external market makers to support the trade to go through can lead to high turnaround time and costly, This approach may lead to some slippage and latency in price discovery on the markets. So here unlike centralized exchanges, Defi exchange relies on the concept of Automated Market Makers. Let’s explore AMM briefly and see how it helps Defi ecosystem
What Is Automated Market Maker(AMM)?
Decentralized trading protocols cannot rely on Order books and manual market makers, to support their trading needs. So they rely on the automated mechanism of some of the market makers like Uniswap, Sushi, Curve, and Balancer, which eliminates the need for a third party, instead of facilitating the user to trade using their private crypto wallet.
Automated market makers directly allow users interested in trading to interact with smart contracts software which enables the required liquidity and price discovery on decentralized exchanges.
Now that you have a brief understanding of order books, AMM’s its time to deep dive into the working of Liquidity Pool
Working Of Liquidity Pool (Using AMMs):
AMM’s is at the heart of the Liquidity pool concept, with AMMs in place traders are allowed to participate in the liquidity pool facilitated by exchanges like UniSwap, etc. Here traders can enter and exit from their positions on token pairs that would be highly illiquid on order book exchanges.
AMMs enabled exchanges Uniswap, bancor is mainly governed by smart contracts which drives the liquidity pools. The liquidity pools on AMM’s comprise a pair of crypto assets like DAI/ ETH or USDC/ETH etc as shown below.
When any Liquidity pool is created, LP(liquidity provider) decides the initial base price and sets the equal supply of crypto-asset pairs. This rule of equal supply applies to all other LPs willing to provide liquidity to the pool.
It is imperative to understand that any trade being executed by traders using AMMs is not controlled by any counterpart, Instead, you’re executing the trade against the liquidity in the liquidity pool. So if you desire to buy the coin, you are not required to have any real seller to do so, you only need to engage with the Liquidity pool, which in turn is governed by smart contracts to ensure sufficient liquidity, to facilitate your buy trade request.
Smart contracts also do the price discovery using the algorithm which is based on the trades that happen in the liquid pool. But you must be wondering why does someone want to supply their assets owned in their wallet and risk the same.
Well, the answer lies in the incentive programs provided by Defi exchanges. As LP you are rewarded in proportion to the amount of liquidity you supply to the Liquidity Pool. For every successful trade which happens in the pool you have contributed, you get the transaction fee that is proportionally distributed among all Liquidity Providers supported by the concerned AMMs
The proportions of the tokens lying in the Liquidity Pool controls the price of assets in consideration. For example, when you buy ETH from the DAI/ETH pool, the supply of ETH is reduced from the pool, and the supply of DAI is increased proportionally. This will increase the price of ETH and decrease the price of DAI.
What Are Some Of The Use Cases Of Liquidity Pool?
We have earlier touched upon some of the use cases of the Liquidity pools, now it's time to capture some of the popular ways in which Liquidity pool helps in functioning DEXs.
We have already discussed AMM which is one of the core use cases of liquidity pools, apart from this they are many more concepts like
Liquidity Mining :
Liquidity mining has been the popular way for crypto investors or traders to put their crypto to work, in earning passive income. Liquidity mining is also popularly termed as Yield Farming.
Liquidity pools concepts are utilized by platforms like Compound or Yearn finance, which makes use of automated yield generation against the pooled assets and pays the reward to LPs as a yield. Using liquidity mining this yield or newly minted tokens are distributed proportionally to each user based on their share of the pool.
To learn more about yield farming please read my article below
To facilitate Project or Governance:
There are many projects or situations where voting via token is required and the counts need sufficient supply for the same, to build some consensus for pushing forward a strong governance proposal. Liquidity pool concepts can be used here to pool the sufficient funds from participating users and enforce some kind of strong governance required for any Defi protocols to sustain or thrive.
Generating Synthetic Tokens :
Liquidity pools are also required to mint synthetic tokens. In order to generate such tokens on the need to provide some crypto assets as collateral on liquidity pool, which in turn connects to the trusted blockchain oracle.
Blockchain oracles are third-party services that provide smart contracts with external information. They serve as bridges between blockchains and the outside world.
to award you the desired synthetic token that’s pegged to whatever asset you’d have pooled as collateral.
Apart from all the above, there are many use cases in decentralized insurance, voting, etc…which we will discuss in detail in some other articles.
Risk Associated With Liquidity Pools:
As discussed, Liquid pools have multiple advantages like Providing Constant liquidity at fluctuating price levels, Automated & fast price discovery, AMMs, etc. But it has its own limitations which need to be factored by every trader looking to take advantage of this concept.
One such risk is termed as:
Impermanent Loss :
One needs to understand this risk factor of impermanent loss, before jumping into the use case of liquidity pools. This is the loss where the original price of your pooled token can nosedive. leading to extreme loss.
Here the loss means less dollar/fiat value at the time of withdrawal than what it was at the time of pooling. This phenomenon arises when the price ratio of assets in a liquidity pool changes drastically
Yes, it means that there is a potential risk of losing all your pooled funds permanently due to some issues with AMM/s smart contract bugs or some kind of manipulation in Liquidity pools. This loss can be irrevocable and needs to be factored in by every trader.
Can this be mitigated?
Yes, there is some possibility. As long as you do not withdraw deposited tokens at a time that the pool is experiencing a change in price ratio, it is still possible to mitigate this loss. Often this loss can be curtailed if the prices of the tokens revert back to the original value. So if you are patient enough & strong-headed, you can still give yourself a chance to bounce back, else if you panic and decide to withdraw you may end up losing the token value permanently
Summary & Food For Thoughts:
Fortune comes to those who have the courage to suffer the pain when things look difficult, so if you are new to this Defi world & don’t have sufficient education regarding the concepts associated with it, you need to invest some time understanding all the nuances associated with your favorite crypto projects.
With the high level of awareness and calculated risk, you may definitely take advantage of Liquidity pools, liquid mining to earn some decent income apart from trading on centralized crypto exchanges.
If you have the patience to stay invested for long and to use the popular tools like Dollar cost average , Yield farming , crypto staking as a seeker you can’t go wrong.
